EU lawmakers have changed the wording of a misleading
paragraph in the most recent
draft version of Ucits V following concerns over the
market’s interpretation of the same section in the
Alternative Investment Fund Managers (AIFM) directive.

Global Investor/ISF reported on December 2 that a
divergence in the market has emerged over the interpretation of
a provision in the depositary liability regime of the AIFM
directive where services are provided by securities settlement
systems - which are run by central securities depositories
(CSDs) and international central securities depositories
(ICSDs).

Article 21(11) states that the use of an SSS’s
services is not considered delegation of custody functions.
Delegation of custody is the precondition for a depositary bank
to be liable for loss of assets in the custody chain. The AIFM
directive imposes strict liability on depositary banks, even
for loss of assets at their sub-custodians.

In light of this, many of the big global custody banks have
analysed how they can reduce or avoid liability for loss of
assets by holding assets directly with CSDs or ICSDs. At the
same time, some of the major ICSDs and CSDs have been marketing
their services as a way to help depositary banks reduce their
liability.

There has been wide disagreement in the market in the past few
months over what services the exemption covers as these
entities provide more than just pure settlement services.

Thorsten Gommel, a partner at PwC "There seems to be some
confusion about Article 21(11) among both market participants
and different regulators. Whereas some regard the exemption
granted to SSSs as an institutional designation, others tend to
see this applicable only for specific services of an SSS
– that is, if it is really the last point in the
custody chain."

One particular area of debate is whether depositary banks would
be able to depend on the non-delegation clause where a
securities settlement system (SSS) uses sub-custodians as its
safekeeping agents. One camp believes these agents are a
necessary part of the CSD infrastructure and that depositary
banks would not be liable for them, while the other camp thinks
otherwise.

But in an emailed statement on November 27 the European
Commission gave a strict definition of the types of services
that would not be subject to delegation of custody and that
therefore would not impose liability on depositary banks for
loss of assets.

The commission limited the services to "(i) initial recording
of securities in a book-entry system through initial crediting,
(ii) providing and maintaining securities accounts at the
top-tier level and (iii) operating a securities settlement
system".

The commission went on to say that as "providing custody is not
part" of these services, Article 21(11) "does not state that a
depositary bank can extricate itself from liability for the
loss of a financial instrument by delegating custody to
securities settlement system."

To Global Investor/ISF’s knowledge the
commission had not informed market participants of its strict
interpretation of Article 21(11) up until that point. Indeed,
three senior-level market participants were "surprised" when
they saw the commission’s emailed comment and one
said this could be a "surprise legal turnaround".

There have been calls for a legal opinion or guidelines to be
issued on the matter, urgently, considering the legal text has
been or is currently being transposed into national law in
member states and many AIFMs must be compliant by July
2014.

In an interesting twist, the same provision in Ucits V was
amended in an
updated version of the draft released on November 29 and
dated November 27.

The article has been altered to include the
Commission’s strict definition of the services
that the exemption covers.

"(16) When a Central Securities Depositary (CSD), as specified
in Article 2 (1)(1) of CSDR or a third-country CSD provides the
services of (i) initial recording of securities in a book-entry
system through initial crediting, (ii) providing and
maintaining securities accounts at the top tier level and (iii)
operating a securities settlement system, as specified in
Section A of the Annex to CSDR, the provision of those services
by this CSD with respect to the securities of the UCITS that
are initially recorded in a book entry system through initial
crediting by this CSD should not be considered a delegation of
its custody functions."

The provision then goes on to say:

"However, entrusting the custody of securities of the Ucits to
a CSD as defined in Article 2(1)(1) of CSDR or to a third
country CSD should be considered a delegation of custody
function."

This is a new insertion in the provision which now makes it
clear that a depositary bank entrusting the custody of assets
to a CSD would be liable for loss of those assets at that
entity.

The sentence directly conflicts with Preamble (42) of the AIFM
directive which states that "Entrusting the custody of assets
to the operator of a securities settlement system …
should not be considered to be a delegation of custody
functions."

One interpretation of the Preamble is that if a depositary bank
puts assets in custody at a CSD, it is not a delegation of
custody and therefore the depositary bank is not liable.
However the Preamble is not a legal document but rather
explains the rationale behind the law and therefore is not
legally binding.

One market participant said the turnaround suggests the
European Commission and European Council "have realised this
'loop-hole' could cause problems" and that they recognise
that "too much room has been left to interpretation on this
issue".

Christopher Stuart-Sinclair, a director in regulatory
consulting at Deloitte, wondered whether the altered text in
Ucits V would create precedent for the interpretation of the
provision in the AIFM directive and pointed out that the change
has been made to the recitals of Ucits V rather than to the
text itself.

"One has to wonder how useful a recital is going to be, it has
no legal enforceability and takes us back to the conundrum of
intent versus legal basis.

"Perhaps the biggest question is why, if there is a growing
perception that the clause may not be particularly helpful, it
has been left in at all, unless it is to avoid leaving AIFMD
orphaned with a reference that is so open to interpretation. It
is also tempting to speculate why a change has been made to the
recitals and not the text itself. Compromise is always
difficult; compromise on ambiguity is in a realm all of its
own."

Global Investor/ISF understand that recitals are not
legally binding because they are not transposed into national
law. However they do form part of the directive and are used to
explain the rationale behind the law.

The commission has not responded to further questions
regarding Article 21(11) of the AIFM directive and changes to
the corresponding section in Ucits V. The European Securities
and Markets Authority (Esma) declined to speak to Global
Investor/ISF but said it is "aware of this issue" and is
"considering how to take this forward".